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Hedge-Fund Outlook: Better for Institutions

Institutional investors are making up the bulk of the new money in hedge funds and are fast becoming the dominant players in the industry. Estimates put institutional money at 60% of hedge-fund assets today.

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By all accounts, 2012 was a pretty uninspiring year for the hedge-fund industry. Plagued by unfavorable comparisons with lower-cost and better-performing mutual funds, the industry ended the year with a scandal, when the best-performing hedge fund, Steve Cohen's SAC Capital Advisors, became embroiled in a scandal. Industry observers are cautiously optimistic that 2013 will shape up to be a better year.

That said, it doesn't look good for SAC. An intense, six-year, multiagency investigation appeared to culminate in November with insider-trading allegations against one of SAC's portfolio managers, but then it rapidly expanded to include Cohen himself. Just 40% of the $14 billion fund's assets are from outside investors, but those investors are yanking their money out almost as fast as terms will allow.
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(BX), with a $550 million stake one of SAC's biggest investors, appears to be content to leave it in Cohen's hands.

Poor performance and a fall from grace has yet to mitigate industry inflows, though. Last year, investors poured $29 billion into hedge funds, with relative-value arbitration strategies taking the greatest share—$24.6 billion, according to data provider eVestment. One trend that nearly everyone has noticed and expects to continue is the increase in institutional money going directly into hedge funds. Last year, investors pulled $28 billion out of funds of funds, but $27 billion went directly into hedge funds.

Institutional investors are making up the bulk of the new money, and are fast becoming the dominant players in the industry. Exact figures are hard to come by, but most estimates put institutional money at 60% of hedge-fund assets today; just five years ago, prefinancial crisis, 60% of the industry's assets were from high-net-worth investors. That's a significant shift in the $2.3 trillion industry, notes Ken Heinz, president of research firm HFR. It also explains why assets in funds of funds are shrinking—institutions are working more with consultants that essentially operate as funds of funds themselves, allocating an institution's money across several funds, and leaving individual investors with smaller allocations to hedge funds, to pay up for the diversification funds of funds aim to provide.

That cost-consciousness on the part of institutions is driving fees down as well—for investors big enough to demand it. "Any midsize to larger investor writing a $15 to $20 million check is going to expect some sort of fee concession," says Noel Kimmel, head of Cantor Fitzgerald's prime brokerage. "A 20%-25% discount is not unreasonable, and larger purchasers will command a bigger discount." Individuals, however, aren't any more likely to successfully negotiate lower fees.

That's not great news for high-net-worth individuals, but it's not necessarily bad. Individuals in midsize funds, those with $1 billion to $5 billion in assets, should keep an eye on performance and growth, though. By all accounts, industry consolidation is making things tough for midsize funds, and as a result, they're actively seeking a bigger piece of the growing institutional outpouring of money. An individual investor in one of these funds wouldn't necessarily know if an institution wrote a big check, Kimmel says, but they should keep an eye on performance, "which can change if there's massive growth in a short period," though whether or not performance will suffer depends on the fund's strategy.

Speaking of performance suffering, equity hedge funds will likely continue to struggle this year. "They got a bad rap for lagging performance in 2012," says Peter Laurelli, vice president of research for eVestment. "But there were a lot of negative things lurking, but the equity markets never really manifested that negativity. In environments like that, hedge funds are going to be consistently defensive." Perhaps that's why the average long/short fund returned just 8.8% in 2012, while the S&P 500 returned 16%.

THE JOBS ACT CAUSED A STIR when it was passed in April 2012 because it dramatically loosened the restrictions on the information hedge funds could share with the general public, even allowing them to advertise. The one sticking point: If a hedge fund took advantage of the looser restrictions, it would have to create "reasonable measures" tighter controls to assure that only accredited investors—generally those with investable assets of $1 million or annual income of $200,000—were allowed into the fund. The Securities and Exchange Commission was charged with creating a definition of what exactly constitutes reasonable measures, but its proposal essentially leaves it in the hands of hedge-fund managers to create their own. So why haven't we seen a flood of marketing? "There were definitely mixed reviews and reactions to the SEC proposal," says Kelli Moll, the partner in charge of Akin Gump's hedge-fund practice in New York. "Some managers are happy with the flexibility, others wanted more of a safe harbor." Expect more industry debate before a final solution, though SEC chief Elisse Walter has said that implementation of the JOBS Act is one of the SEC's top priorities for 2013.